The "too connected to fail" problem could have been averted with some simple regulatory steps; ideally in the future we should have a central exchange for these contracts with collateral requirements. I've discussed the incredible growth of the CDS market several times on this blog. But I always wondered why it was't more carefully regulated.
Economist: (2006) OVER a year ago, a whiff of something nasty filled the nostrils of the world's financial regulators. It came, appropriately, from the back end of the credit-derivatives market, an unregulated asset class that was growing so fast that banks and hedge funds that dabbled in it had lost track of their trades.
In other markets where trading is private (rather than on an exchange), the problem might have seemed minor, involving thankless back-office tasks with monotonous names like matching and confirmation. But this time regulators saw a threat to the stability of banks, because of the popularity of credit-default swaps (CDSs), instruments that disperse lending risk around the financial system.
...Last month Alan Greenspan, former chairman of the Federal Reserve, startled bond traders at a dinner in New York with both a friendly pat and a slap on the wrist. Credit derivatives, he gushed, were “becoming the most important instruments I've seen in decades.” But he then went on to say how appalled he was at the “19th-century technology” used to trade credit-default swaps, with deals done over the phone and on scraps of paper.
The answer, apparently, is in a bill sponsored by McCain economic advisor Phil Gramm -- the Commodity Futures Modernization Act, passed in 2000, which exempts swaps from regulation! [Thanks to reader STS for making me aware of this.]
Did McCain know about this earlier in the week when, after first pretending there was no crisis in financial markets, he ranted about the betrayal of the noble American worker by the greed and corruption of Wall Street?
MotherJones: ...But Gramm's most cunning coup on behalf of his friends in the financial services industry—friends who gave him millions over his 24-year congressional career—came on December 15, 2000. It was an especially tense time in Washington. Only two days earlier, the Supreme Court had issued its decision on Bush v. Gore. President Bill Clinton and the Republican-controlled Congress were locked in a budget showdown. It was the perfect moment for a wily senator to game the system. As Congress and the White House were hurriedly hammering out a $384-billion omnibus spending bill, Gramm slipped in a 262-page measure called the Commodity Futures Modernization Act. Written with the help of financial industry lobbyists and cosponsored by Senator Richard Lugar (R-Ind.), the chairman of the agriculture committee, the measure had been considered dead—even by Gramm. Few lawmakers had either the opportunity or inclination to read the version of the bill Gramm inserted. "Nobody in either chamber had any knowledge of what was going on or what was in it," says a congressional aide familiar with the bill's history.
It's not exactly like Gramm hid his handiwork—far from it. The balding and bespectacled Texan strode onto the Senate floor to hail the act's inclusion into the must-pass budget package. But only an expert, or a lobbyist, could have followed what Gramm was saying. The act, he declared, would ensure that neither the SEC nor the Commodity Futures Trading Commission (CFTC) got into the business of regulating newfangled financial products called swaps—and would thus "protect financial institutions from overregulation" and "position our financial services industries to be world leaders into the new century."
...But the Enron loophole was small potatoes compared to the devastation that unregulated swaps would unleash. Credit default swaps are essentially insurance policies covering the losses on securities in the event of a default. Financial institutions buy them to protect themselves if an investment they hold goes south. It's like bookies trading bets, with banks and hedge funds gambling on whether an investment (say, a pile of subprime mortgages bundled into a security) will succeed or fail. Because of the swap-related provisions of Gramm's bill—which were supported by Fed chairman Alan Greenspan and Treasury secretary Larry Summers—a $62 trillion market (nearly four times the size of the entire US stock market) remained utterly unregulated, meaning no one made sure the banks and hedge funds had the assets to cover the losses they guaranteed.
In essence, Wall Street's biggest players (which, thanks to Gramm's earlier banking deregulation efforts, now incorporated everything from your checking account to your pension fund) ran a secret casino.